Tax court shoots down IRS’s highest and best use argument in conservation easement case and refuses to impose penalties

On May 6, 2014, the Tax Court (Goeke J.) issued yet another significant decision in the area of conservation easements. Palmer Ranch Holdings Ltd. v. Commissioner, T.C. Memo 2014-79. The property at issue was 82 acres of land in Sarasota, Florida. The IRS conceded that the donation of the easement encumbering that land met all of the requirements of section 170, but contested the taxpayer’s claim that the value of the easement was $23,942,500. The dispute between the IRS and the taxpayer centered around the “highest and best use” of the property before the easement. The taxpayer argued that the property could be rezoned to permit denser development, thus making the property more valuable. The IRS argued that the proposed rezoning plan was not “reasonably probable,” thus the property could only be developed under the less-dense zoning designation.

Under the Treasury Regulations applicable to conservation easements, a taxpayer may value an easement by determining the value of the encumbered property at its highest and best use prior to the easement, and then subtracting the value of the property’s highest and best use after the easement. This method is known as the “Before and After” method of valuing an easement. The “highest and best” use of property must be a use that is reasonably probable in the reasonably near future, though it need not be the current use or an intended use of the property. Hilborn v. Commissioner, 85 T.C. 677 (1985).

In the past year, the IRS has repeatedly argued that the taxpayer’s claimed highest and best use was not reasonably probable, thus the value of the easement is greatly overstated. In two recent cases, the Tax Court sided with the IRS, resulting in a dramatic decrease in the value of the donated easement. Mountanos v. Comm’r, T.C. Memo 2013-138; Whitehouse v. Comm’r, 139 T.C. No. 13. Palmer Ranch is significant because the Tax Court sided with the taxpayer, dismissing all of the IRS’s arguments that rezoning was not reasonably probable.

The IRS first argued that the taxpayer had attempted (and failed) to rezone property in the past, thus rezoning was not reasonably probable. The Tax Court disagreed, distinguishing other cases that relied on zoning history, and noting that the previous denial was a 3-2 vote, which could have changed over time. The Tax Court also noted that significant development had been permitted on other adjoining parcels and that the IRS’s own land use planner recognized that there are significant developable areas in the wildlife corridor that runs through the property.

The IRS also argued that the proposed highest and best use was not reasonably probable because the property lacked sufficient road access and the adjoining neighborhood would oppose the development, which would require access to their roads. The Tax Court dismissed the IRS’s position as to road access and neighborhood opposition, observing that concerns about neighborhood opposition required too many assumptions that the Tax Court was not willing to adopt, specifically: 1) that the residents would object to ingress and egress on the property, 2) that any possible objection would be a factually based argument strong enough to preempt such access and 3) the Board of County Commissions would find merit in the argument. The Tax Court further noted that the adjoining property was owned by the taxpayer and that the taxpayer would likely be willing to give a hypothetical buyer an easement to the road on the adjoining property.

Finally, the Tax Court disagreed with the IRS’s claim that the wildlife corridor found on the property would preclude rezoning, siding with the taxpayer in its interpretation of the zoning regulation and finding that a 660 foot radius surrounding the protected areas would be sufficient.

After concluding that the taxpayer’s highest and best use of the property was the appropriate basis for valuing the property, the Tax Court did apply a haircut to the taxpayer’s value, finding that that the calculations by the taxpayer’s appraiser overstated the growth of the real estate market. Notwithstanding this overly rosy view, the Court concluded that the taxpayer’s reliance on the appraisal was reasonable and in good faith, thus accuracy-related penalties were not applicable.

This case again illustrates the immensely significant role that the arbiter plays in making a judgment as to “highest and best use.” While the Tax Court has made that judgment call in the IRS’s favor on several occasions, here, the Tax Court made that judgment call in the taxpayer’s favor. This opinion will assist taxpayers arguing a highest and best use that requires a zoning change. However, at the end of the day, the judgment call as to highest and best use is, well, up to the judge.

A copy of Palmer Ranch Holdings Ltd. v. Commissioner can be found here.